Chapter 7 The International Monetary System and the Balance of Payments International Business, 6th...

chapter 7

The International

Monetary System

and the Balance

of Payments

International Business, 6th E

ditionGriffin & Pustay

Copyright 2010 Pearson Education, Inc. publishing as Prentice Hall

Chapter Objectives

• Discuss the role of the international monetary system in promoting international trade and investment

• Explain the evolution and functioning of the gold standard

• Summarize the role of the World Bank Group and the International Monetary Fund in the post-World War II international monetary system established at Bretton Woods


Chapter Objectives (continued)

• Explain the evolution of the flexible exchange rate system

• Describe the function and structure of the balance of payments accounting system

• Differentiate among the various definitions of a balance of payments surplus and deficit


International Monetary System

The international monetary system

establishes the rules by which

countries value and exchange their

currencies and provides a mechanism for

correcting imbalances between a

country’s international payments and

receipts.

The international monetary system exists because most countries have their own currencies. A means of exchanging these currencies is needed if business is to be conducted across national boundaries. The cost of converting foreign money into a firm’s home currency—a variable critical to the profitability of international operations—depends on the smooth functioning of the international monetary system.


Balance of Payments

The Balance of Payments (BOP)

Accounting System records

international transactions and

supplies vital information about the

health of a national economy and

likely changes in its fiscal and

monetary policies.

International businesspeople also monitor the international monetary system’s accounting system, the balance of payments. BOP statistics can be used to detect signs of trouble that could eventually lead to governmental trade restrictions, higher interest rates, accelerated inflation, reduced aggregate demand, or general changes in the cost of doing business in any given country.


History of the International Monetary System

• The Gold Standard

• The Sterling-Gold Standard

• The Collapse of the Gold Standard

• The Bretton Woods Era

• The End of the Bretton Woods Era

• The international monetary system can trace its roots to the allure of gold and silver, both of which served as media of exchange in early trade between tribes and in later trade between city-states. The coming slides will present the evolution of the IMS from the gold standard to the modern day.


The Gold Standard

Countries agree to buy or sell their

paper currencies in exchange for gold

on the request of any individual or firm

and to allow the free export of gold

bullion and coins.

• In 1821 the United Kingdom became the first country to adopt the gold standard. During the nineteenth century, most other important trading countries—including Russia, Austria-Hungary, France, Germany, and the United States—did the same.

• As long as firms had faith in a country’s pledge to exchange its currency for gold at the promised rate when requested to do so, many actually preferred to be paid in currency. Transacting in gold was expensive.


Fixed Exchange Rate System


• The gold standard effectively created a fixed exchange rate system. An exchange rate is the price of one currency in terms of a second currency. Under a fixed exchange rate system the price of a given currency does not change relative to each other currency. The gold standard created a fixed exchange rate system because each country tied, or pegged, the value of its currency to gold. The United Kingdom, for example, pledged to buy or sell an ounce of gold for 4.247 pounds sterling, thereby establishing the pound’s par value, or official price in terms of gold. The United States agreed to buy or sell an ounce of gold for a par value of $20.67. The two currencies could be freely exchanged for the stated amount of gold, making £4.247 = 1 ounce of gold = $20.67. This implied a fixed exchange rate between the pound and the dollar of £1 = $4.867, or $20.67/£4.247.

Sterling-Based Gold Standard

• British pound sterling was the most important currency from 1821 to 1918.

• Most firms would accept either gold or British pounds.

• The international monetary system during this period is often called a sterling-based gold standard. The pound’s role in world commerce was reinforced by the expansion of the British Empire, including present-day Canada, Australia, New Zealand, Hong Kong, Singapore, India, Pakistan, Bangladesh, Kenya, Zimbabwe, South Africa, Gibraltar, Bermuda, and Belize. In each colony, British banks established branches and used the pound sterling to settle international transactions among themselves. Because of the international trust in British currency, London became a dominant international financial center in the nineteenth century, a position it still holds. The international reputations and competitive strengths of such British firms as Barclays Bank, Thomas Cook, and Lloyd’s of London stem from the role of the pound sterling in the nineteenth-century gold standard.


The Collapse of the Gold Standard

• Economic pressures of WWI

• Countries suspended pledges to buy or sell gold at currencies’ par values

• Gold standard readopted in 1920s

• Dropped during Great Depression

• British pound allowed to float in 1931

– Float: value determined by supply and demand


• During World War I, the sterling-based gold standard unraveled. With the outbreak of war, normal commercial transactions between the Allies (France, Russia, and the United Kingdom) and the Central Powers (Austria-Hungary, Germany, and the Ottoman Empire) ceased. The economic pressures of war caused country after country to suspend their pledges to buy or sell gold at their currencies’ par values. After the war, conferences at Brussels (1920) and Genoa (1922) yielded general agreements among the major economic powers to return to the prewar gold standard. Most countries readopted the gold standard in the 1920s despite the high levels of inflation, unemployment, and political instability that were wracking Europe. The resuscitation of the gold standard proved to be short lived, however, due to the economic stresses triggered by the worldwide Great Depression. The Bank of England was unable to honor its pledge to maintain the value of the pound. On September 21, 1931, it allowed the pound to float, meaning that the pound’s value would be determined by the forces of supply and demand and the Bank of England would no longer redeem British paper currency for gold at par value. After the UK abandoned the gold standard, a “sterling area” emerged as some pegged their currencies to the pound. Other countries tied the value of their currencies to the U.S. dollar or the French franc. The harmony of the international monetary system degenerated further as some engaged in a series of competitive devaluations of their currencies. By deliberately and artificially lowering (devaluing) the official value of its currency, each nation hoped to make its own goods cheaper in world markets, thereby stimulating its exports and reducing its imports.

The Bretton Woods Era

• 44 countries met in Bretton Woods, New Hampshire, in 1944

• Goal: to create a postwar economic environment to promote worldwide peace and prosperity

• Renewed gold standard on modified basis (dollar-based)

• Created International Bank for Reconstruction and Development and International Monetary Fund

• Determined not to repeat the mistakes that had caused World War II, Western diplomats desired to create a postwar economic environment that would promote worldwide peace and prosperity. In 1944 the representatives of 44 countries met at a resort in Bretton Woods, New Hampshire, with that objective in mind. The Bretton Woods conferees agreed to renew the gold standard on a greatly modified basis. They also agreed to the creation of two new international organizations that would assist in rebuilding the world economy and the international monetary system: the International Bank for Reconstruction and Development and the International Monetary Fund. These organizations are discussed further on the following slides.


International Bank for Reconstruction and Development (the World Bank)

• Goal 1: to help finance reconstruction of European economies

– Accomplished in mid-1950s

• Goal 2: to build economies of the world’s developing countries

• The International Bank for Reconstruction and Development (IBRD) is the official name of the World Bank. Established in 1945, the World Bank’s initial goal was to help finance reconstruction of the war-torn European economies. With the assistance of the Marshall Plan, the World Bank accomplished this task by the mid-1950s. It then adopted a new mission—to build the economies of the world’s developing countries.

• As its mission has expanded over time, the World Bank has created three affiliated organizations: 1) The International Development Association, 2) The International Finance Corporation, and 3) The Multilateral Investment Guarantee Agency.

• Together with the World Bank, these constitute the World Bank Group (see next slide). The World Bank is owned by its 184 member countries. To reach decisions, the World Bank uses a weighted voting system that reflects the economic power and contributions of its members. The United States currently controls the largest bloc of votes (16 percent), followed by Japan (8 percent), Germany (4 percent), the United Kingdom (4 percent), France (4 percent), and six countries with 3 percent each: Canada, China, India, Italy, Russia, and Saudi Arabia. To finance its lending operations, the World Bank borrows money in its own name from international capital markets. Interest earned on existing loans it has made provides it with additional lending power. New lending by the World Bank averaged $11 billion per year from 2001 to 2005.


Figure 7.2 Organization of the World Bank Group


According to its charter, the World Bank may lend only for “productive purposes” that will stimulate economic growth within the recipient country. The World Bank cannot finance a trade deficit, but it can finance an infrastructure project, such as a new railroad or harbor facility, that will bolster a country’s economy. It may lend only to national governments or for projects that are guaranteed by a national government, and its loans may not be tied to the purchase of goods or services from any country. Most important, the World Bank must follow a hard loan policy; that is, it may make a loan only if there is a reasonable expectation that the loan will be repaid. In response to criticism from poor countries, the World Bank established the International Development Association (IDA) in 1960. The IDA offers soft loans, loans that bear some significant risk of not being repaid. IDA loans carry no interest rate, although the IDA collects a small service charge (currently 0.75 percent) from borrowers. The loans also have long maturities (normally 35 to 40 years). The two other affiliates of the World Bank Group have narrower missions. The International Finance Corporation (IFC), created in 1956, is charged with promoting the development of the private sector in developing countries. Acting like an investment banker, the IFC, in collaboration with private investors, provides debt and equity capital for promising commercial activities. The other World Bank affiliate, the Multilateral Investment Guarantee Agency (MIGA), was set up in 1988 to overcome private-sector reluctance to invest in developing countries because of perceived political riskiness. MIGA encourages direct investment in developing countries by offering private investors insurance against noncommercial risks.

Objectives of the International Monetary Fund

• To promote international monetary cooperation

• To facilitate the expansion and balanced growth of international trade

• To promote exchange stability, to maintain orderly exchange arrangements among members, and to avoid competitive exchange depreciation

• To assist in the establishment of a multilateral system of payments

• The Bretton Woods attendees believed that the deterioration of international trade during the years after World War I was attributable in part to the competitive exchange rate devaluations that plagued international commerce. To ensure that the post-World War II monetary system would promote international commerce, the Bretton Woods Agreement called for the creation of the International Monetary Fund (IMF) to oversee the functioning of the international monetary system. Article I of the IMF’s Articles of Agreement lays out the organization’s objectives.


Objectives of the International Monetary Fund

(continued)

• To give confidence to members by making the general resources of the IMF temporarily available to them and to correct maladjustments in their balances of payments

• To shorten the duration and lessen the degree of disequilibrium in the international balances of payments of members


Membership in the IMF

• Open to any country willing to agree to rules and regulations

• 185 member countries as of 2008

• Membership requires payment of a quota

• Membership in the IMF is available to any country willing to agree to its rules and regulations. As of April 2006, 184 countries were members. To join, a country must pay a deposit, called a quota, partly in gold and partly in the country’s own currency. The quota’s size primarily reflects the global importance of the country’s economy, although political considerations may also have some effect.

• The size of a quota is important for several reasons:

1. A country’s quota determines its voting power within the IMF.

2. A country’s quota serves as part of its official reserves.

3. The quota determines the country’s borrowing power from the IMF. Each IMF member has an unconditional right to borrow up to 25 percent of its quota from the IMF. IMF policy allows additional borrowings contingent on the member country’s agreeing to IMF-imposed restrictions—called IMF conditionality—on its economic policies.


A Dollar-Based Gold Standard

• Countries agreed to peg the value of currencies to gold

• U.S. $ keystone of system

• Fixed exchange rate system

• Adjustable peg

• Functioned well in times of economic prosperity

• The Breton Woods system worked well as long as countries were experiencing economic prosperity. However, beginning in the late 1960s, British productivity decreased relative to that of its major international competitors, and the pound’s value weakened. The Bank of England had to intervene continually in the foreign currency market, selling gold and foreign currencies to support the pound. In so doing, however, the Bank’s holdings of official reserves, which were needed to back up the country’s Bretton Woods pledge, began to dwindle. International currency traders began to fear the Bank would run out of reserves. As that fear mounted, international banks, currency traders, and other market participants became unwilling to hold British pounds in their inventory of foreign currencies. They began dumping pounds on the market as soon as they received them. A vicious cycle developed: As the Bank of England continued to drain its official reserves to support the pound, the fears of the currency-market participants that the Bank would run out of reserves were worsened.


The End of the Bretton Woods System

• Susceptible to speculative “runs on the bank”

• U.S. $ became only source of liquidity necessary to expand international trade

• People questioned the ability of U.S. to meet obligations (Triffin Paradox)

• IMF created special drawing rights (SDRs) – paper gold

• Bretton Woods system ended August 15, 1971


• These runs on the British and French central banks were a precursor to a run on the most important bank in the Bretton Woods system—the U.S. Federal Reserve Bank. Because the supply of gold did not expand in the short run, the only source of the liquidity needed to expand international trade was the U.S. dollar. Under the Bretton Woods system, the expansion of international liquidity depended on foreigners’ willingness to continually increase their holdings of dollars. Foreigners were perfectly happy to hold dollars as long as they trusted the integrity of the U.S. currency, and during the 1950s and 1960s the number of dollars held by foreigners rose steadily. As foreign dollar holdings increased, however, people began to question the ability of the United States to live up to its Bretton Woods obligation. This led to the Triffin paradox: foreigners needed to increase their holdings of dollars to finance expansion of international trade, but the more dollars they owned, the less faith they had in the ability of the United States to redeem those dollars for gold. The less faith foreigners had in the United States, the more they wanted to rid themselves of dollars and get gold in return. If they did this, however, international trade and the international monetary system might collapse because the United States did not have enough gold to redeem all the dollars held by foreigners.

• As a means of injecting more liquidity into the international monetary system while reducing the demands placed on the dollar as a reserve currency, IMF members agreed in 1967 to create special drawing rights (SDRs). IMF members can use SDRs to settle official transactions at the IMF. Thus, SDRs are sometimes called “paper gold.”

The End of the Bretton Woods System

• As a means of injecting more liquidity into the international monetary system while reducing the demands placed on the dollar as a reserve currency, IMF members agreed in 1967 to create special drawing rights (SDRs). IMF members can use SDRs to settle official transactions at the IMF. Thus, SDRs are sometimes called “paper gold.”


Performance of the International Monetary System since 1971

• Most currencies began to float

• Value of U.S. $ fell relative to most major currencies

• Group of Ten agreed to restore fixed exchange rate system with restructured rates of exchange

• In a dramatic address on August 15, 1971, President Richard M. Nixon announced that the United States would no longer redeem gold at $35 per ounce. The Bretton Woods system was ended. In effect, the bank was closing its doors. After Nixon’s speech, most currencies began to float, their values being determined by supply and demand in the foreign-exchange market. The value of the U.S. dollar fell relative to most of the world’s major currencies. The nations of the world, however, were not yet ready to abandon the fixed exchange rate system. At the Smithsonian Conference, held in Washington, D.C. in December 1971, central bank representatives from the Group of Ten agreed to restore the fixed exchange rate system but with restructured rates of exchange between the major trading currencies. The U.S. dollar was devalued to $38 per ounce but remained inconvertible into gold, and the par values of strong currencies such as the yen were revalued upward. Currencies were allowed to fluctuate around their new par values by ±2.25 percent, which replaced the narrower ±1.00 percent range authorized by the Bretton Woods Agreement.


International Monetary System since 1971

• Development of floating exchange rate system

– Supply and demand for a currency determine its price in the world market

– Managed float – central banks can affect supply and demand

• Legitimized in 1976 with the Jamaica Agreement


• Free-market forces disputed the new set of par values established by the Smithsonian conferees. Speculators, believing the dollar and the pound were overvalued, sold both and hoarded currencies they believed were undervalued, such as the Swiss franc and the German mark. The Bank of England was unable to maintain the pound’s value within the ±2.25 percent band and in June 1972 had to allow the pound to float downward. The United States devalued the dollar by 10 percent in February 1973. By March 1973 the central banks conceded they could not successfully resist free-market forces and so established a flexible exchange rate system. Under a flexible (or floating) exchange rate system, supply and demand for a currency determine its price in the world market. Since 1973, exchange rates among many currencies have been established primarily by the interaction of supply and demand. The current arrangements are often called a managed float (or, a dirty float) because exchange rates are not determined purely by private-sector market forces. The new flexible exchange rate system was legitimized by an international conference held in Jamaica in January 1976. According to the resulting Jamaica Agreement, each country was free to adopt whatever exchange rate system best met its own requirements. The United States adopted a floating exchange rate. Other countries adopted a fixed exchange rate by pegging their currencies to the dollar or some other currency. Still others adopt crawling pegs, where the peg was allowed to change gradually over time.

Table 7.1 The Groups of Five, Seven, and Ten


Table 7.2 Key Central Banks

Country Bank

Canada Bank of Canada

European Union European Central Bank

Japan Bank of Japan

United Kingdom Bank of England

United States Federal Reserve Bank


European Union

• Believed flexible system would hinder ability to create integrated economy

• Created European Monetary System to manage currency relationships

• ERM participants maintained fixed exchange rates among their currencies

• Facilitated creation and adoption of euro

• The strategy adopted by European Union (EU) members is based in the belief that flexible exchange rates would hinder their ability to create an integrated European economy. In 1979 EU members created the European Monetary System (EMS) to manage currency relationships among themselves. Most EMS members chose to participate in the EU’s exchange rate mechanism (ERM). ERM participants pledged to maintain fixed exchange rates among their currencies within a narrow range of ±2.25 percent of par value and a floating rate against the U.S. dollar and other currencies. The exchange rate mechanism facilitated the creation of the EU’s single currency, the euro.


International Debt Crisis

• OPEC quadrupled world oil prices

– Resulted in inflationary pressures in oil-importing countries

– Exchange rates adjusted

– Transfer of wealth

• Countries borrowed more than they could repay


• The flexible exchange rate system instituted in 1973 was immediately put to a severe test. In response to the Israeli victory in the Arab-Israeli War of 1973, Arab nations imposed an embargo on oil shipments to countries such as the United States and the Netherlands, which had supported the Israeli cause. As a result, the Organization of Petroleum Exporting Countries (OPEC) succeeded in quadrupling world oil prices from $3 a barrel in October 1973 to $12 a barrel by March 1974. This rapid increase in oil prices caused inflationary pressures in oil-importing countries. The new international monetary arrangements absorbed some of the shock caused by this upheaval in the oil market, as exchange rates adjusted to account for changes in the value of each country’s oil exports or imports. The higher oil prices acted as a tax on the economies of the oil-importing countries. Many of the oil-exporting countries went on spending sprees, using their new wealth to improve their infrastructures or to invest in new facilities (such as petroleum refineries) to produce wealth for future generations. The unspent petrodollars were deposited in banks in international money centers such as London and New York City. The international banking community then recycled these petrodollars through its international lending activities to help revive the economies damaged by rising oil prices. The international banks were too aggressive in recycling these dollars. Many countries borrowed more than they could repay. The financial positions of these borrowers became precarious after the oil shock of 1978-1979 when the price of oil triggered another round of worldwide inflation. Interest rates on these loans rose, as most carried a floating interest rate, further burdening the heavily indebted nations. The international debt crisis formally began when Mexico requested a rescheduling of its debts, a moratorium on repayment of principal, and a loan from the IMF to help it through its debt crisis. In total, more than 40 countries in Asia, Africa, and Latin America sought relief from their external debts.

Approaches to Resolve the International Debt Crisis

The Baker Plan The Brady Plan


The 1985 Baker Plan (named after then U.S. Treasury Secretary James Baker) stressed the importance of debt rescheduling, tight IMF-imposed controls over domestic monetary and fiscal policies, and continued lending to debtor countries in hopes that economic growth would allow them to repay their creditors. In Mexico’s case, the IMF agreed to provide a loan package only if private foreign banks holding Mexican debt agreed to reschedule their loans and provide Mexico with additional financing. However, the debtor nations made little progress in repaying their loans. Debtors and creditors alike agreed that a new approach was needed. The 1989 Brady Plan (named after the first Bush administration’s treasury secretary Nicholas Brady) focused on the need to reduce the debts of the troubled countries by writing off parts of the debts or by providing the countries with funds to buy back their loan notes at below face value.

1985 Baker Plan (named after then U.S. Treasury Secretary James Baker) stressed the importance of debt rescheduling, tight IMF-imposed controls over domestic monetary and fiscal policies, and continued lending to debtor countries in hopes that economic growth would allow them to repay their creditors. In Mexico’s case, the IMF agreed to provide a loan package only if private foreign banks holding Mexican debt agreed to reschedule their loans and provide Mexico with additional financing. However, the debtor nations made little progress in repaying their loans. Debtors and creditors alike agreed that a new approach was needed.

• It helps policy makers understand the performance of each country’s economy in international markets. It also signals fundamental changes in the competitiveness of countries and assists policy makers in designing appropriate public policies to respond to these changes. International businesspeople need to pay close attention to countries’ BOP statistics for several reasons, including the following:

• 1. BOP statistics help identify emerging markets for goods and services.

• 2. BOP statistics can warn of possible new policies that may alter a country’s business climate, thereby affecting the profitability of a firm’s operations in that country.

• 3. BOP statistics can indicate reductions in a country’s foreign-exchange reserves, which may mean that the country’s currency will depreciate in the future, as occurred in Thailand in 1997. Exporters to such a country may find that domestic producers will become more price competitive.

• 4. As was true in the international debt crisis, BOP statistics can signal increased riskiness of lending to particular countries.

• The 1989 Brady Plan (named after the first Bush administration’s treasury secretary Nicholas Brady) focused on the need to reduce the debts of the troubled countries by writing off parts of the debts or by providing the countries with funds to buy back their loan notes at below face value.







The Balance of Payments Accounting System

The BOP accounting system is a

double-entry bookkeeping system

designed to measure and record all

economic transactions between

residents of one country and residents of

all other countries during a particular

time period. Copyright 2010 Pearson Education, Inc. publishing as Prentice Hall

Figure 7.4 The Asian Contagion


The Asian currency crisis erupted in July 1997, when Thailand, which had pegged its currency to a dollar-dominated basket of currencies, was forced to unpeg its currency, the baht, after investors began to distrust the abilities of Thai borrowers to repay their foreign loans and of the Thai government to maintain the baht’s value. Not wanting to hold a currency likely to be devalued, foreign and domestic investors converted their bahts to dollars and other currencies. The Thai central bank spent much of its official reserves desperately trying to maintain the pegged value of the baht. After Thailand was forced to abandon the peg on July 2, the baht promptly fell 20 percent in value. As investors realized that other countries in the region shared Thailand’s overdependence on foreign short-term capital, their currencies also came under attack and their stock markets were devastated. Indonesia was hit the worst by the so-called Asian contagion (see Figure 7.4). Aftershocks of the crisis spread to Latin America and Russia, and the Russian government effectively defaulted on its foreign debts. All told, the IMF and the Quad countries pledged over $100 billion in loans to help restore these countries to economic health.

Balance of Payments (BOP) Accounting System

• Measures and records all economic transactions between residents of one country and residents of all other countries during specified time period

• Provides understanding of performance of each country’s economy in international markets

• Signals fundamental changes in country competitiveness

• Assists policy makers in designing appropriate public policies


Four Important Aspects of the BOP Accounting System

• Records international transactions made in some time period

• Records only economic transactions

• Records transactions between residents of one country and all other countries

– Residents include individuals, businesses, government agencies, nonprofit organizations

• Uses a double-entry system


• Four important aspects of the BOP accounting system need to be highlighted:

• 1. The BOP accounting system records international transactions made during some time period, for example, a year.

• 2. It records only economic transactions, those that involve something of monetary value.

• 3. It records transactions between residents of one country and residents of all other countries. Residents can be individuals, businesses, government agencies, or nonprofit organizations, but defining residency is sometimes tricky. Persons temporarily located in a country—tourists, students, and military or diplomatic personnel—are still considered residents of their home country for BOP purposes. Businesses are considered residents of the country in which they are incorporated.

• 4. The BOP accounting system is a double-entry system. Each transaction produces a credit entry and a debit entry of equal size. In most international business dealings, the first entry in a BOP transaction involves the purchase or sale of something—a good, a service, or an asset. The second entry records the payment or receipt of payment for the thing bought or sold. Debit entries reflect uses of funds; credit entries indicate sources of funds. Under this framework, buying things creates debits, and selling things produces credits.

Major Components of the BOP Accounting System

Current Account

Capital Account

Official Reserves

Errors and Omissions


The BOP accounting system can be divided conceptually into four major accounts. The first two accounts—the current account and the capital account—record purchases of goods, services, and assets by the private and public sectors. The official reserves account reflects the impact of central bank intervention in the foreign-exchange market. The last account—errors and omissions—captures mistakes made in recording BOP transactions.

Types of Current Account Transactions

• Exports and imports of goods

• Exports and imports of services

• Investment income

• Gifts

• The goods account records sales and purchases of goods. The difference between a country’s exports and imports of goods is called the balance on merchandise trade. The services account records sales and purchases of such services as transportation, tourism, medical care, telecommunications, advertising, financial services, and education. The difference between a country’s exports of services and its imports of services is called the balance on services trade. The third type of transaction recorded in the current account is investment income. The fourth type of transaction in the current account is unilateral transfers, or gifts between residents of one country and another. Unilateral transfers include private and public gifts.


Capital Account

Foreign Direct Investment

PortfolioInvestment


The second major account in the BOP accounting system is the capital account, which records capital transactions—purchases and sales of assets—between residents of one country and those of other countries. Capital account transactions can be divided into two categories: foreign direct investment (FDI) and portfolio investment.FDI is any investment made for the purpose of controlling the organization in which the investment is made, typically through ownership of significant blocks of common stock with voting privileges. Under U.S. BOP accounting standards, control is defined as ownership of at least 10 percent of a company’s voting stock. A portfolio investment is any investment made for purposes other than control. Portfolio investments are divided into two subcategories: short-term investments and long-term investments. Short-term portfolio investments are financial instruments with maturities of one year or less. Included in this category are commercial paper; checking accounts, time deposits, and certificates of deposit held by residents of a country in foreign banks or by foreigners in domestic banks; trade receivables and deposits from international commercial customers; and banks’ short-term international lending activities, such as commercial loans. Long-term portfolio investments are stocks, bonds, and other financial instruments issued by private and public organizations that have maturities greater than one year and that are held for purposes other than control.

Table 7.4 Capital Account Transactions


Current account transactions invariably affect the short-term component of the capital account. The first entry in the double-entry BOP accounting system records the purchase or sale of something—a good, a service, or an asset. The second entry typically records the payment or receipt of payment for the thing bought or sold. In most cases, this second entry reflects a change in someone’s checking account balance, which in the BOP accounting system is a short-term capital account transaction.

Table 7.5 BOP Entries, Capital Account

Debt (Outflow) Credit (Inflow)

Portfolio (short-term) Receiving a payment from a foreigner

Making a payment to a foreigner

Buying a short-term foreign asset

Selling a domestic short-term asset to a foreigner

Portfolio (long-term) Buying back a short-term domestic asset from its foreign owner

Selling a short-term foreign asset acquired previously

Buying back a long-term domestic asset from its foreign owner

Selling a domestic long-term asset to a foreigner

Foreign direct investment

Buying a foreign asset for purposes of control

Selling a long-term foreign asset previously acquired

Buying back from its foreign owner a domestic asset

Selling a domestic asset to a foreigner


• Capital inflows are credits in the BOP accounting system. They can occur in two ways:

1. Foreign ownership of assets in a country increases.

2. Ownership of foreign assets by a country’s residents declines.

• Capital outflows are debits in the BOP accounting system. They also can occur in two ways:

1. Ownership of foreign assets by a country’s residents increases.

2. Foreign ownership of assets in a country declines.

Official Reserves Account

• Records level of official reserves

• Four types of assets

– Gold

– Convertible currencies

– SDRs

– Reserve positions at the IMF


Official Reserves Account

Assets

Gold

Convertiblesecurities

SDRs

Reservepositions


The third major account in the BOP accounting system, the official reserves account, records the level of official reserves held by a national government. These reserves are used to intervene in the foreign-exchange market and in transactions with other central banks. Official reserves comprise four types of assets: 1) Gold, 2) Convertible currencies, 3) SDRs, and 4) Reserve positions at the IMF. Official gold holdings are measured using a par value established by a country’s treasury or finance ministry. Convertible currencies are currencies that are freely exchangeable in world currency markets.

Errors and Omissions

• BOP must balance

• Current Account + Capital Account + Official Reserves Account = 0

• Current Account + Capital Account + Official Reserves Account + Errors and Omissions = 0


The last account in the BOP accounting system is the errors and omissions account. One truism of the BOP accounting system is that the BOP must balance. In theory, the following equality should be observed: Current Account + Capital Account + Official Reserves Account = 0.However, this equality is never achieved in practice because of measurement errors. The errors and omissions account is used to make the BOP balance in accordance with the following equation:Current Account + Capital Account + Official Reserves Account + Errors and Omissions = 0.Sometimes, errors and omissions are due to deliberate actions by individuals who are engaged in illegal activities such as drug smuggling, money laundering, or evasion of currency and investment controls imposed by their home governments. Politically stable countries, such as the United States, are often the destination of flight capital, money sent abroad by foreign residents seeking a safe haven for their assets, hidden from the sticky fingers of their home governments. Given the often illegal nature of flight capital, persons sending it to the United States often try to avoid any official recognition of their transactions, making it difficult for government BOP statisticians to record such transactions. Residents of other countries who distrust the stability of their own currency may also choose to use a stronger currency, such as the dollar or the euro, to transact their business or keep their savings.

Table 7.6. U.S. Balance of Payments in 2007


Defining BOPs Surpluses and Deficits

Official Settlements Balance reflects changes in a country’s official reserves; essentially, it records the net impact of the Central Bank’s intervention in the foreign-exchange market in support of the local currency


Chapter 7 The International Monetary System and the Balance of Payments International Business, 6th...

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